Delay in the Expansion from 2.5G to 3G Wireless Networks: A Real Options Approach Dr. Fotios Harmantzis (Speaker) & P. Tanguturi Assist. Professor, Stevens Institute of Technology Director, Real Options Group (ROG) PerfEcTNet Research Group

Outlook of Presentation Introduction and Problem Parameters and Assumptions Numerical Results Analysis –Study the effect of key parameters Investment cost, Volatility, Expansion Factor Conclusion References 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Introduction and Problem Facts: –The cellular market has seen an unprecedented growth in subscribers and is still growing. –The services have emerged from basic voice services to text messaging and data services. –Need for high speed data services have been promised by 3 rd Generation (3G) wireless networks even before actual implementation. –It’s a known fact that operators in Europe paid exorbitant prices for 3G spectrum in auctions. –Revenues to respective governments have ranged from 20 Euros per capita to 650 Euros per capita. –Notion among the operators was to own as much as spectrum as they can, no matter how much it costs them. –Operators face this daunting task to evolve their infrastructure cost effectively 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Cont.. Problem –The requirement of network architecture that supports new bandwidth intensive service is demanding and costly. –Due to high price paid for spectrum there has been delay in the introduction of the services. –Operators are posed with certain questions: What will be the cost of deployment of network? How are the investment costs going to be recovered? How and when to release applications that will drive the market? –The fact is that future is uncertain. Solution –Uncertainties related with high-technology investment are better managed by valuing flexibility rather than static valuation i.e., NPV. –We propose the use of Real Options approach to valuate investment decisions, help in decision making process, and identify which factors affect the decision making process. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Objective Company considers expanding or delay expansion of a 2.5G network to the next generation of networks, the 3G, using real options approach 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Approach to Problem Step 1: Parameters and Assumptions Step 2: Capital Budgeting –Investment cost break down Step 3: Use of Option pricing framework to value the option –Option to Expand 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Parameters and Assumptions New York Metro market for analysis. Scenarios –Scenario A: Company has acquired the spectrum to upgrade from 2.5G to 3G –Scenario B: Company has not acquired the spectrum to rollout 3G network yet. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Parameters and Assumptions (Cont.) S o – Present value of the company forms the underlying asset for our derivative K - Present value of Investment cost –Capital Expenditure (CapEx) –Scenario A: It is the capital expenditure required to upgrade the network –Scenario B: It is the sum of capital expenditure and license cost (assumed to be $ m) T - 5 Years Volatility (σ) – 18% annually, 5 years historical price movements of stock price of company. Risk Free Interest (r f ) – 3.12%, 5 Years US Treasury Bond Rate Expansion Factor (E) – Post-expansion growth factor of the company 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Investment Cost Break Down YearYear 1Year 2Year 3Year 4Year 5 Initial Cell Sites New Cell Sites CapEx (in million) $167.76m$54.49m$67.14m$71.92m$87.44m CapEx = No of cell sites * Cell site construction cost * Base station equipment* Antenna* Switch* Radios* Integration Present Value of Investment cost Scenario A (excludes license cost) : $286.00m Scenario B (including spectrum cost): $6,636.00m (discounted using WACC = 20% for the time of the project) 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Parameters revisited S o – Present value of the company –$27,761m K - Present value of Investment cost –Scenario A: $286m (excludes license cost) –Scenario B: $6,636m (CapEx + License cost) T - 5 Years Volatility (σ) – 18% annually, 5 years historical price movements of stock price of company. Risk Free Interest (r f ) – 3.12%, 5 Years US Treasury Bond Rate Expansion Factor (E) – Post-expansion growth factor of the company 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Option to Expand Binomial Method 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Valuation Scenario AScenario B Traditional Approach (No growth assumptions) NPV = $27,475mNPV = $21,125m Option to ExpandOption to Expand= $27,822.54m Static Valuation = $27,752.61m (Expansion Factor of 1%) Extra Premium = $69.93m (0.02%) Option to Expand=$27,768.74m Static Valuation = $23,901.10m (Expansion Factor = 10%) Extra Premium = $ m (16%) 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Analysis Effect of Expansion Factor to Option Value (both scenarios) 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Analysis (Cont.) Effect of Volatility to Option Value (both scenarios): Expansion Factor 1% 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Analysis (Cont.) Scenario A Scenario B Effect of Volatility to Option Value (both scenarios): Expansion Factor 20% 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Conclusion Path to 3G depends not only on purchasing the spectrum but also on other factors such as expansion factor, volatility and investment cost. When expansion factor is varied our analysis suggest that Option value is high when the investment cost is low. When investment cost are high, it requires at least 10 fold increase in the company’s value to expand. When investment cost is low, it is other way round, even a small expansion factor can lead to exercising the option. With low investment cost and high volatilities it is a good decision to expand. It is important to understand that the success of 3G will be largely based on market both penetration and business models. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Critique Selection of input parameters and assumptions –The volatility factor used to measure change in the value of underlying asset is difficult to estimate in reality. –We considered capital cost as the investment cost, it can be extended to include operational expenditure. –For the underlying asset we can use present value of future cash flows (i.e., the revenues) instead of current value of the company. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Future Work Enhancing the cash flow estimate Consideration for operational expenditure, marketing cost, and revenues. There can be several other Options embedded which can be explored by further study on the topic. 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group

Thank You Dr. Fotios Harmantzis Venkata Praveen, Tanguturi PerfEcTNet Research Group Telecommunications Management Stevens Institute of Technology Hoboken, NJ {fharmant, 15 th Biennial International Telecommunications Conference 2004 PerfEcTNet Research Group